The Peril of Operating Leverage

Most investors have solid understanding of the concept of financial leverage, the degree to which a company uses fixed-income securities such as debt and preferred equity to lever up return on equity. However, another type of leverage, namely operating leverage, is often obliterated despite of its much-deserved significance to any serious investor.

Operating leverage can be defined as the degree of change in operating income that results from a change in revenue. Simply put, a company with a high degree of operating leverage will suffer more rapidly declining operating income when revenues decline. Conversely, when revenues improve, the company’s operating income will increase more. Naturally this applies more to companies with high fixed costs than to companies with high variable costs as the latter can cut costs (variable) more easily when revenue declines.

A question then comes to an investor’s mind – why does this matter?

In the author’s opinion, the analysis of the degree of operating leverage can dramatically influence investment decision making, particularly at inflexion points in the business cycle or in the economic cycle.

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• WTW 30-Year Financial Data
• The intrinsic value of WTW
• Peter Lynch Chart of WTW

Let’s take an example of Macy’s revenue and operating income from 2007 to 2009.

Macy’s revenue for the three-year period totals $26.3 billion, $24.9 billion and $23.5 billion respectively in 2007, 2008 and 2009.

An easy calculation shows revenue declined by 5.4% and 5.6% in 2010 and 2011.

Macy’s operating incomes, adjusted for a $5.8 billion unusual expense in 2008, were $1.86 billion, $1.40 billion and $1.06 billion in those three years. Operating income declined 24.7% and 24.2% in 2008 and 2009, or more than four times the degree of revenue decline.

Shrewd readers may have noticed that 2007 represents in inflection point from an economic cycle perspective. Now here is another example from a business cycle perspective.

Apollo Education Group is one of the leading for-profit education institutions. Here is the revenue and operating income information for the past four years:

Again, the decline in revenue produced a much larger decline in operating income.

So we have walked through two examples of operating leverage working against a particular company. However, we haven’t touched upon the implications in terms of valuation and investment decision making. Many non-professional investors calculate intrinsic values by projecting out revenues and earnings for the next couple of years to arrive at a terminal value then discount that terminal value using a discount rate to arrive at the present value. There is nothing inherently wrong with this method. The peril lies in situations where investors assume earnings are a constant percentage of revenues, which completely ignores the effect of operating leverage.

A more sound way is to calculate the historical operating leverage to get an idea of the degree of operating leverage of the business. Then one should build that degree of operating leverage into future projections. Very often amateur investors fall into value traps because they are not cognizant of the degree of operating leverage in the first place. A recent example involves the investors who purchased shares of Weight Watchers International. In this case, a very high degree of operating leverage of Weight Watchers’ business model vastly exacerbated the bottom line when revenue declined. The peril of operating leverage, unbeknownst to those Investors who got caught off guard by the magnitude of decline in earnings power, should have played a vital role in the security analysis process.